Thursday, July 08, 2010

Trade models I teach - the Ricardian trade model

I myself have participated in this, in the Introductory Macroeconomics course I TA for at the University of Michigan. We always include a lecture that pits pro-free-trade arguments against anti-free-trade arguments, and we make sure that the former always come out the "winner" at the end of the day. We use the very simplest models of trade, and we never mention industrial policy or the manufacturing sector or mercantilism. And another four hundred students tramps off to be America's next generation of businesspeople, lawyers, journalists, professors, and voters...

So to follow up on this, I thought I would explain the trade models I teach - and those I don't teach but which are in common use - and illustrate why these models say that free trade is always good. The first model I talk about will be - must be - the classical, or "Ricardian" trade model, which is the one I teach in introductory macro courses.

The Ricardian trade model deals with aggregate trade between countries - in other words, it treats each country as a single person, saying "Brazil can produce 100 cows or 50 peppers, Argentina can produce 75 cows or 25 peppers." You may already be able to see how this setup already assures that free trade is always optimal. The reason is: if Brazil is a single person, and Argentina is a single person, they wouldn't agree to trade if trade weren't good for both of them.

This is actually a very deep principle in economics. It's called the "first welfare theorem," and it says: two people will not engage in any economic transaction that doesn't benefit both of them. Thus, any economic transaction that happens - such as international trade, for example - must make both parties better off. the only way a transaction is bad is if it has some kind of effect on a third party not involved in the transaction - a side effect, or "externality." An example is pollution; when I sell you a piece of metal that I mined by dumping arsenic in a river, people get hurt who had no say in whether or not we did the deal.

But if there's only two people in the world ("Brazil" and "Argentina"), there can't be any externality, by definition! Thus, no matter what kind of forces drive international trade in the Ricardian setup, it must conclude that free trade is always and everywhere good. Game over.

But just in case you want to know, the Ricardian theory is all about something called "comparative advantage". This means that each country specializes in the thing it can produce relatively cheaply. To use an example from Mankiw's intro textbook, suppose I'm a lawyer who can make $2000/hr. lawyering or $100/hr. typing. And suppose my secretary types only half as fast as I do. It still makes sense for me to pay my secretary to do the typing, even though I'm twice as good at typing as he is, because I can make more money for an hour of lawyering than for an hour of typing. Even though I have an "absolute advantage" in typing, my secretary has a "comparative advantage" in typing, because he can't lawyer at all. It's impossible to have a comparative advantage in everything, so countries will always have an incentive to trade.

So that's how that works. But notice - "comparative advantage" is not necessary to conclude that free trade is always good. That conclusion was assured by the fact that the model treats each country as a single person. The mere fact that free trade allows more trade is what makes it automatically good in that sort of setup, comparative advantage or no; if trade is bad for one of the country-persons, that country-person will simply refuse to trade!

In fact, the only argument one can muster against free trade in the Ricardian setup is the "winners and losers" idea. This is the idea that, even if a country as a whole benefits from free trade, some people inside the country (for example, producers who lose their jobs when cheap imports put them out of business) might lose out. And this is the "argument against trade" that we always trot out in Econ 102 to explain why people aren't always happy about trade. But in the end, this argument always loses, because we just say "Instead of restricting free trade, we should find ways to have the 'winners' compensate the 'losers'" (you see those terms, "winners" and "losers," a lot in articles about trade). And voila, free trade is good.

So if you read a commentary by some smarty-pants columnist who says "Of course free trade is good, because comparative advantage exists, you dummy!", then now you realize that he's wrong. If externalities exist, then comparative advantage might not be enough to make free trade good. If you have a model that assumes no externalities, like the Ricardian model and many others, then free trade is good whether there's comparative advantage or not.

But where's the proof? If there are no externalities (and as long as a nation distributes its gains from trade properly among its citizens, which we assume it can), then free trade is always good. But how do we know there are no negative externalities to trade? The Ricardian model just assumes they don't exist! Of course, you can't prove a negative, so the burden of proof is on a free trade opponent to come up with an idea for a negative externality (a few have tried; so far, they have not been paid much attention). But merely having an assumption in place that no negative externality exists is not the same as evidence in favor of free trade.

If I were to teach trade models honestly, I would say: "Look, if these assumptions are right, then free trade is always good. But the fact is, we're not sure they're right, and we need to look into the matter a lot more before we bet our credibility on the statement that free trade is always good." But I don't teach trade models honestly, because scientific skepticism will not help my students pass their exams.